My Adventures in Europe

The following post was my (unsuccessful) attempt at winning the "International Actuaries" essay contest in 2009. Perhaps I needed to be more "mathy" to sway the all-actuary panel. Well at least I hope my non-actuarial readers enjoy this lighter read.

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I will be completely honest with you. When I decided to take a job allowing me to live in Europe, I was not thinking about my career or my professional development. Rather I was thinking about the adventure of a lifetime – living on a continent rich in culture that had been calling for my return ever since I backpacked through the beautiful cities and countryside three years prior. The thought of getting back there kept me disciplined to pass my (actuarial fellowship) exams as fast as I could. With that last exam behind me, destiny was mine. I was heading back to Europe!

I was hired by one of the large US consulting firms as part of a team of five actuaries and consultants assigned the task of starting an office in Europe. I accepted the job without being given the details of which city or country I'd be living in; Europe was all I needed to hear. Essentially we were exporting the variable annuity concept that was so popular in the US and Japan and bringing it to Europe.

The first of my many interesting experiences had me spending several months working on site with a German client and it was here the adventure began. “How different could office life be in a foreign country?” I wondered. As I learned, it's the little things that really throw you for a loop.

Getting a cup of coffee would seem simple enough. However, when presented with a machine with several options in a language you don't understand, well it turns into a trial and error process – and just hope no one is watching. The cafeteria experience was a different story. Every day, I would stroll around the various serving stations, instinctively looking up at the menu boards, only to be reminded that it was all in an unfamiliar language. Determined not to go starving, I used the international form of communication of pointing and nodding to get the food which looked most appealing. It was always a fun game of seeing if it tasted like what I thought it was. Sure, this isn't everyone's cup of tea, but when the little mundane things in life are turned on their heads, life for me gets a little more interesting.

While my on site experiences were interesting, even more so were the random jobs involved in setting up the home office. One day I received a call from my colleagues in the US, instructing me to hop on the evening train to Amsterdam – I was going apartment shopping the next morning.

So there I was the next morning at the realtor's office in the middle of Amsterdam, meeting my agent Tijs. The first thing he asked me was whether I had a bike with me. While I couldn't help but notice the plethora of bikes on the street, the question still took me by surprise. Fortunately, the Realtors had an extra for me. Tijs and I spend the better half of the morning riding around Amsterdam checking out apartments, dressed in suits no less. My instructions were simple. I was to find a place that could sleep five and also be used as office space. As such, my adventures in Europe took another interesting twist – it would be five American actuaries living and working in the same house in Amsterdam – it was like a really bad reality show idea.

The early days were indeed the craziest as we were trying to function as a normal, professional office without the normal office amenities such as printers, or an internet connection. I found myself in one situation where I needed to send some results to a client by noon one day. I was working up to the last minute to get the job completed. There I was with a finished product and a half hour to spare, but no internet connection. I packed up my laptop and ran down the street looking for the first place that had wireless internet. As it would turn out the first place I came across was one of those coffee shops you can only find in the Netherlands – and I'm not talking about the Dutch answer to Starbucks. As I hit the send button, I took a brief second to take in the scene. I was pretty certain that I was the only person in there using the internet for business purposes. I couldn't help but chuckle. Only in Amsterdam.

Over time, the work life became a bit more normal. With the distraction of setting up an office behind me, it became clear that there was substantial opportunity for me to develop as an actuary. Before my time in Europe, I was an actuarial student, working in the variable annuity trenches, running models and crunching numbers. But when I came to Europe, I brought a unique set of skills with me that put me in a position where I could transform into a consultant and provide valuable advice to senior management looking to introduce variable annuities into their own country.

Quite frankly, the US variable annuity guarantees came out of the gate too fast for their own good. The concept of adding a guaranteed floor to a mutual fund type investment was a great sales proposition especially in light of the down market that preceded it. However, in the haste to get these products out while the memories of market losses were fresh in investors minds, insurers exposed themselves to a number of risks that could have been avoided.

At their essence, these products are exotic put options. For those familiar with the Black – Scholes option pricing formula, you will recall that the higher the underlying asset's volatility results in a higher option price. Well, the early versions of these products allowed investors the option to put all of their money in a single highly volatile fund such as a tech fund. This meant that for a knowledgeable investor, they could essentially buy a product that was way under priced. Now it wasn't that the US companies didn't realize this at the time – they did. Rather, they were more focused on piggybacking the guarantee onto an existing product, and changing the base product would have delayed the time to market (among other reasons).

In contrast, many European insurers were starting from scratch building these products. On top of that, they were a product generation behind the US and Japan, which they could use to their advantage to learn from their predecessors' mistakes. My background put me in a position to help show them the way.

While the American companies continued to push out bigger and richer guarantees, many European companies took their time rolling out products, and focused on strong risk management fundamentals baked into the product development process. Due to the willingness of these companies to listen and learn, my colleagues and I were able to advise them on some of the pitfalls. For example, some European companies would allow their policyholders to choose their asset allocation, and then charge them based on the amount of equity exposure (volatility level), reducing adverse selection.

Looking back to the products I've worked on with European insurers, many are better built to minimize losses from the recent severe down markets. While annuity players around the globe are tweaking their product designs these days, many US insurers will have the most work to do. My advice to them would be to take a look at their European counterparts to learn some valuable lessons of their own.

As I've recently moved back to the US, I bring with me three very full years of memories, experiences, and most importantly professional development. Having the opportunity to work directly with senior actuaries was a valuable experience. Working in a small office and doing a little bit of everything including marketing and presenting are all skill sets that I have taken home with me. Europe has given me the adventures that I craved and allowed me to develop into an actuary and consultant along the way.

What Exactly is Variable Annuity Hedging?

I was planning on writing up a summary of some of the variable annuity hedging effectiveness reports, but I received some questions asking to give a little background on what exactly hedging is. Therefore, before I dive into hedge effectiveness, I will dedicate today's blog to describing hedging basics. I will keep this at a high level, but if you are really dying to learn more or have any questions please let me know.

Q: In one sentence or less, what is variable annuity hedging?
A: It is a risk management technique that allows insurance companies to transfer the capital market risk (i.e. stock prices dropping) involved in issuing annuity guarantees to other parties for a fixed cost.

Q: Why do insurers need to hedge?
A: When an insurance company sells a variable annuity guarantee to a policyholder, it is taking on capital market risk. Typically the big risks for these products are if stocks or interest rates drop or if market volatility increases. Additionally, some of the richer benefits also offer guaranteed growth (roll up) rates, and there is a risk that these rollup rates outpace the underlying fund growth.

While insurance companies are in the business of taking on risk, they are most comfortable in risk that can be pooled. For example, in car insurance, insurers have a pretty good idea, that for every 1,000 16 year old boys they insure, x% will get into an accident that on average will result in say $5,000 in claims. It's not fortune telling, it's just using statistics to know that if you have a large enough group of people with similar characteristics, the insurer can estimate the total cost of claims for the group and then charge each person in the group appropriately to have a high likelihood of covering all claims. This is how insurance works most of the time. However, a guarantee on the stock market is not a poolable risk because generally speaking all policyholders have a guarantee on the same stock market. If the S&P goes down, then everyone has claims. There is no law of averages.

Fortunately, hedging techniques can be used to successfully manage this risk.

Q: Do insurers try to make a profit with hedging?
A: No. It is common to confuse the concept of hedging with hedge funds. These are totally different concepts. Hedging is a technique used by insurance companies to mitigate risk. In contrast hedge fund managers use fancy investment strategies and try to get filthy rich.

Q: In layman's terms, how does hedging work?
A: Hedging is complex, no doubt about it.

First, lets start with a product to hedge, so you can picture the risk. The simplest (and most boring) of the guarantees is a Guaranteed Minimum Accumulation Benefit (GMAB). Let's say there is a 10 year deferral period and very basic return of premium guarantee. This means the policyholder invests a premium - say $100,000. This money goes into mutual fund type investments. The insurer will guarantee the policyholder that at the end of 10 years, they will receive at a minimum their initial $100,000 investment or their account value at year 10, if it has appreciated (I don't think a product this boring is actually sold by any major insurers, but it's easy to understand).

So what is the risk to the insurance company? It is the risk that at the end of 10 years, the investor's account is worth less than $100,000. So if the value drops to $90,000 the insurer would have to pay a claim in year 10 of $10,000. Simple enough, right? Now if the insurer didn't hedge, they would have an unknown claim amount when they issued the policy. Or they could transfer the risk to the derivatives market and lock in a fixed cost that would cover claims regardless of what happens in the future. Still with me? Let me use an analogy to illustrate what I'm talking about.

Lets say in January of this past year, you walk into a gas station and they are selling gift certificates that if you pay $2, the gift certificate allows you to receive 1 gallon of gasoline at a point in time in the future. Over this past year, we've seen gas prices rise and fall, but if you owned this certificate, you would be able to get that gallon of gas for the $2 you paid, regardless of what the price of gas is actually at. Therefore you locked in the future price of gas at $2 and transferred the risk of gas prices changing to whomever sold you the certificate. In other words, you hedged against the future price of gas changing... making something that was uncertain now certain.

The same concept is applied with hedging guarantees, only a bit more complicated than buying a gift certificate at a gas station (or else I'd be out of a job)... The insurer uses fancy computers and sophisticated financial modeling techniques to figure out which hedge assets they should invest in, so when the markets move, the change in asset value will offset the change in their expected claim (liability) value. Using this technique, regardless of market fluctuations they can then lock in a fixed cost of issuing the guarantee.

So let's put this all together now in terms of the GMAB product discussed above. The insurer calculates the hedge cost (expected claims if hedged) they would expect to pay on a policy, let's say this is $1,000 at issue. They can then lock in the cost of issuing the guarantee by purchasing hedge assets that would insulate the insurer from any changes in the markets. So if after they lock in the hedge say that the stock market drops and by the time year 10 comes around, the policyholder's account value has dropped to 90,000. This means the insurer must pay them $10,000. Fortunately, the insurer has this money. They set aside $1,000 for the hedge cost. In addition, the hedge assets they "purchased" have increased by $9,000. Adding these together provides the insurer with $10,000 to pay the claim. Similarly, had the policyholder's account value dropped to 80,000, the insurer would owe 20,000. This 20,000 would be funded with the $1,000 they set aside for the hedge cost plus the $19,000 increase in the hedge assets. Thus, by hedging, insurers transfer the market risk to the derivatives market.

At a high level this is how hedging works. The uncertain risk is transferred for a more certain set of cashflows by entering into hedge assets whose payoff help to offset the change in liability cashflows that are owed to the policyholder. Hedging isn't perfect, and there will be some mismatch between the asset and liability cashflows, but in my next post, we'll take a look at how effective hedging has been in this recent period of declining markets and high volatility.

The Full Story on Annuities

Annuities and their issuers have been all over the news lately - getting a lot of bad press. It's one thing to report the truth about the industry, but its another thing to talk negatively about a subject an author doesn't understand and put out misguided information to scare investors (there is a time and place for this sort of behavior, but it requires running for a political office).

One misconception that I hear a lot involves the cost of variable annuity guarantees. Some say they are too expensive. Others say they don't charge enough. Well, which one is it?

Also, lately I've heard a lot of negative comments that hedging doesn't work. Insurers don't understand the risks they are taking and don't know how to manage them. Similar comments have been made addressing the capital infusions insurers are requiring.

Well, here is the full story: annuities are complex products and pricing and hedging annuities is even more complex. In order to draw conclusions on pricing and hedging these products, you need to understand how they work and what the goal is. In addition, the capital requirements and accounting rules that va sellers must abide to have inefficiencies, that weren't fully realized until current markets, and as a result they have penalized insurers in unintended ways. Discussions are currently underway to correct these inefficiencies. This is not to say that insurers aren't hurting right now and insurers don't need more capital, but there's more than meets the eye.

For financial advisors and individual investors, it is extremely important that you understand the whole story on these issues in order to form your own opinion on the strengths of these companies and their products. My goal is to deliver you the full picture on a number of these "hot topics" over the next few weeks.

The first topic I will dive into is the effectiveness of companies managing annuity guarantee risk. I'll set the scene and provide some (optional) background reading on this issue below, but to keep this blog at a manageable length, I will put the meat in my next blog.

There were two reports put out earlier this year that have investigated the effectiveness of hedging, one was by Moody's (August 2008 - Link to summary)and the other by Milliman (May 2008 - Link). They both concluded that hedging works in periods of "market turmoil' as stated in the title of Moody's report.

Well "market turmoil" is a relative term, or else what what do you call the last 3 months since that report was published. Milliman just published a new report (link), looking at how hedge programs have performed in September and October, during the period of "really really really bad market turmoil" (I had to answer my own question above). It is a bit technical, but a great report that provides a lot of incite. I would encourage a read (and please let me know if you have any questions).

While, many have heard of Moody's, one of the top rating agencies, I doubt many have heard of Milliman, so let me tell you a little bit about them.

Milliman is one of the top independent insurance consulting companies in the world. They are the global leaders in variable annuity financial risk management and have a market share of about 70% (which is huge). I would say two things about these guys. They understand hedging and its effectiveness better than anyone else. They also are critiquing their own work in a way, which some may say adds bias. However they use real, factual data from insurer hedging programs in their report to draw their conclusions, and I believe everything they say to be true. In addition, Moody's previous report drew similar conclusions to Milliman's May report. However, I would also say, that in a report like this, it takes a trained eye to dissect how they say things to read in between the lines, which I will add commentary on.

For full disclosure, I would add that Milliman is my former employer, and while I have much respect for the people there, I do not have any vested interests in the company.

Please read my next blog entry (above) to get the full story on hedging variable annuity guarantees.

Guardian Life & Annuity Gets Rating Upgrade

In times where many life insurers are in danger of getting ratings downgrades, Guardian Life just got an upgrade from A.M. Best.

"A.M. Best Co. has upgraded the financial strength ratings (FSR) to A++ (Superior) from A+ (Superior) and the issuer credit ratings (ICR) to "aa+" from "aa" of The Guardian Life Insurance Company of America (Guardian) (New York, NY) and its core subsidiaries, The Guardian Insurance & Annuity Company, Inc. and Berkshire Life Insurance Company of America. A.M. "

This is good news for anyone needing more confidence before investing in annuity products.

While Guardian is not one of the biggest players in the variable annuity market space, they appear to be better capitalized than a number of their competitors. This could certainly help to drive sales if they chose to push annuities going forward as company ratings are at the forefront of investors minds these days.

Guardian currently offers two base Variable Annuity contracts and a number of guarantee riders including a Guaranteed Lifetime Withdrawal Benefit (GLWB) and a Guaranteed Minimum Income Benefit (GMIB).

Guardian can thank their diversified product offerings as well as a strong enterprise risk management platform which has allowed them to to reduce their risk and stay well capitalized during these difficult times.

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New wave of Variable Annuity Products on the Horizon

In light of the current market environment, a number of the annuity providers are redesigning or repricing their guarantees. The bottom line is that due to increased market volatility, it is a lot more expense for insurers to offer market guarantees - up to 80% more expensive than a year ago.

That really only leaves the insurers with 3 choices:
1) take the hit on profits
2) pass on the higher costs to the consumer
3) redesign the products to bring the price down in the current market environment.

Up till now, insurers have been stuck with option number one by default - hence the historically low stock prices of market players. However, as it is vitially important that insurance companies stay profitable over the long run so they can make good on their insurance obligations, change is inevitably in order. That is why all the major players are looking to modify their guarantees. He's some early publicly available information:

AXA: Redesign GMIB. They used to offer two rollup rates - a 6% & 6.5% to increase the guarantee base. Now they are taking away the 6.5% option. In addition, they will be raising the rider cost by 15 basis points. Also, they will allow the GMIB policyholder an additional option to switch to a Guaranteed Lifetime Withdrawal Benefit at age 85.

ING: Retooling asset allocation restrictions. By reducing the amount of volatility in the policyholder's portfolio (i.e. percent equity holdings), they are able to reduce the cost of offering the guarantee.

Others that are looking into redesign but haven't publicly given details include John Hancock & the Hartford. And look for more to make announcements soon.

The va market is turning an a corner by bringing an end to the "arms race" of competing on richer and richer guarantees, which just wasn't viable over the long run. In the future we will continue to see several trends including:
1) less carriers promoting GMIBs
2) a reduction in rollup features
3) increase focus on ratchets

These redesigns are just a product of our economy. Just as when the price of filling up your gas tank increases as a response to higher oil prices, annuity guarantees are effected by the same market forces. In the case of va's, the raw ingredients are the the hedging instruments in the derivatives market. But fortunately in these hard times, the insurance companies can turn out their "fuel efficient" models much quicker.

However, those who are considering buying a variable annuity with a guaranteed rider can still get some good deals on the existing products if they act soon. Just be sure to look at the ratings on the insurance carrier before purchasing a va.

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Big Annuity Players are Thinking Outside the Box for Capital Relief

Some of the big annuity players are so determined on getting government funding that they have taken on a new attitude: if the treasury won't change their eligibility criteria then we will change our company to meet the criteria.

As I mentioend in my previous blog, in order to qualify for the treasury's Troubled Asset Relief Program's (TARP) $700 billion, insurers would need to be recognized as a bank or a thrift that is regulated at the federal level. A number of annuity players already fell into one of those categories, such as Metlife, Prudential, John Hancock, and even AIG.

However a couple big names were not eligable, including Hartford, Lincoln and Genworth. Well they did some out of the box thinking in an attempt to get then "TARP elibable." He's my take on what went on in one of their executive meetings sometime last week:

CEO: I can't believe the treasury says we are not eligible for any of that $700 Billion of taxpayers money. This is going to kill us.

President: It's just not fair - they shouldn't be able to exclude us just because we are not a bank or a thrift. We need that money as bad as the next guy.

Exec Vice President: We'll we could buy a thrift (half joking)?

CEO: That's briliant! I think I know of a cheap one in Florida that we may be able to get for as low as $10 Million!

So, yeah, Hartford, Lincoln and Genworth suddenly entered into the thrift acquisition business for the sole purpsose of becoming TARP eligible. For companies in need of capital to go out and spend $10 Million to essentially buy a membership card for the troubled asset relief program club, it doesn't really seem like the most effecient use of their assets. We have the treasury's poorly thought out eligibility criteria - that excluded about have the industry - to thank for that.

So why did these three companies go out and spend millions to get on this list? Well insurers can apply for between 1% - 3% of their total risk based assets, up to a cap of $25 billion. Hartford said it would expect to receive $1.1 - $3.4 Billion. So While Lincoln and Genworth have not discussed what they believe they could get from thsi program, they did list assets of $173.3 Billion & $109.6 Billion from their Q3 earnings statment.

We wait with baited breath to see if these companies' thrift investments pay off and they are allowed to become elibible for the TARP. This would give these companies a much need boost to their capital.

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Survival of the Fittest in the Variable Annuity Industry

11/12/2008

The last few months haven't exactly been the best of times for the insurance industry. And this past week wasn't any better. A number of companies stocks took another sharp hit after Goldman's Chris Necaypor released his analysis of the industry earlier this week. On top of that, it seems like ratings cuts may be around the corner for a number of companies if they don't figure out how to raise more capital.

So what does this mean for the VA industry? Well the market for variable annuities certainly isn't going anywhere. There is still a huge mass of baby boomers set to retire over the coming years and the VA will continue to serve as an important component of their investment portfolio. However the landscape of companies competing in the market looks like it may get a face lift..

Darwin's survival of the fittest may indeed be applied to the VA industry. The top 15 players already make up nearly 90% of market sales. The smaller companies fighting for that last 10% may likely exit and sell their business and its possible that an acquisition or two may take place among the larger players ( Necaypor hinted at Metlife & other strong P&C companies being potential buyers). Further more, all signs indicate that the arm's race of richer and richer guarantees is coming to an end.

So what exactly happened this week?

Goldmans' Downgraded a number of insurance companies due to the following reasons:

• Exposure to poor commercial real estate holdings

• Decreased revenue from annuities and other asset based fees products

• Anticipation of capital calls to avoid rating cuts

Ratings cuts... nothing a few Billion can't fix.

Remember the Troubled Asset Relief Program (TARP) - you know that $700 Billion the senate passed through. Initially Insurers not named AIG had taken the position that they didn't need or want any of that. Now it looks as if some insurers have had a change of heart. Lucky for for them, they may be able to claim a stake in it too... well some of them. According to the treasury (who appears to be making up the rules as they go along), some insurance companies may be able to get a slice if they can show they are affiliated to federally regulated banks or thrifts (sounds like the finance version of proving you have Native American blood to get Casino money). Unfortunately, other insurers who expressed interest in this money will be turned away. In their case they may have to resort to more traditional, and likely less desirable means of raising capital, such as:

• Issuing more stock and hoping they find buyers

• Borrow Funds via issuing bonds which would likely be at higher, less desirable rates do to the lowered ratings (see a downward spiral here)

• Merger / Acquisition / Selling off a business line (as a last resort)

So we'll see in the coming weeks who's getting some of government (tax payers) funding and who wishes they were. There has also been some early indications that those who do not qualify for the money may have a few tricks up their sleeves to get on the list.

While Necaypor is not recommending ownership in most of these companies, it's not so bad for the policyholders who have purchased guarantees that are now “in the money” meaning the insurer is on the hook for paying out the difference between the initial deposit (or higher) and the current value in the underlying mutual fund type investments. Most insurers have hedging programs or reinsurance agreements set up to pay for these claims.

In Necaypor's analysis, one company did come out above the rest – Metlife. They seem to be well capitalized compared to their peer group. This seemed to be the rational for Necaypor to issue a “neutral” rating compared to a sell that most of the other companies. But there is still a good chance that Metlife does apply for federal money – not because they need it to maintain their rating, but rather to stock up funds so they can acquire some of the weaker annuity players. Should be an interesting few weeks in the insurance industry...

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